1 Money and Interest Rate Outline • What money means in economics? • The cost of holding money and the demand for money. • The relationship between bond prices and interest rates. • The inverse relationship between interest rate and investment – a revisit. • The relationship between money supply, interest rate, investment. • How does the central bank affect the money supply?

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2 What “Money” Means in Economics? • Money is the most liquid asset 1 and it can be used to hold our wealth. • Obviously, we can hold our wealth in other less liquid assets such as real estate, cars and etc. • In economics , the phrase “we have a lot of money” means we have chosen to hold a larger portion of our wealth in the form of liquid asset. • For everyone else , the phrase “we have a lot of money” means we are wealthy. 1 An asset is said to be very liquid if it can easily converted into goods and services (i.e., easy to buy stuffs).

3 The Cost of Holding Money and the Demand for Money The Cost of Holding Money • The opportunity cost of holding money is the interest rate. Why? ⇒ To some extent, the choice to hold money is a choice among different assets. ⇒ When we decide to hold our wealth in the form of money, we give up the opportunity to hold our wealth in other form of assets. ⇒ The value of money DOES NOT “grow” and give us any interest. (Think about what happens if you put a $100 bill under your pillow tonight and then take it out a year later, it is the same $100) ⇒ However, other assets such as bonds give us a return such as interest. ⇒ Therefore, the opportunity cost of holding money is the interest rate (the rate of return we could have earned if we hold our wealth in the form of bonds and etc.). • Question: What happens to the cost of holding money when interest rate rises?

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5 2) Interest rate, r ⇒ Holding all else constant, when r ↑ , cost of holding money ↑ ⇒ demand for money ↓ . ⇒ There is a negative relationship between r and MD. • In notation form: MD = demand for liquidity = L(r, Y) Note: • In economics, we also call the demand for money as a demand for liquidity because money is the most liquid asset in the economy. If we want to hold more money, this means we want to hold more liquid assets.

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